Question

a. If price of Food increases, show the IE and SE on a separate diagram if F is a normal good.

b. If price of Food increases, show the IE and SE on a separate diagram if F is an inferior good.

c. If price of Food increases, show the IE and SE on a separate diagram if F is a Giffen  good.

d. If price of Food decreases, show the IE and SE on a separate diagram if F is a normal good.

e. If price of Food decreases, show the IE and SE on a separate diagram if F is an inferior good.

f. If price of Food decreases, show the IE and SE on a separate diagram if F is a Giffen  good.

2. Suppose two goods X and Y are perfect complements. (2 points for each part)

a. If price of X increases, show the IE and SE.

b. If price of X decreases, show the IE and SE.

c. Is X a normal good, inferior good, or Giffen good. Why? What about Y?

3. (Bonus) Suppose two goods X and Y are perfect substitutes. You have $100 to spend between these two goods. The price of X is $1 and the price of Y is $1. The MRSx,y=2.

(2 points for each part)

a. Show the BL1 and IC (label this U1) on a diagram. How much X and Y do you consume to maximize your utility? Label this point A.

b. Using the same diagram, show the IE and SE if price of X is $1.5.

c. Using the same diagram, show the IE and SE if price of X is $3.

Answer 1

In the diagram given below, AB is original line and AB1 is new budget line after price change. Food is on horizontal axis and clothing on vertical axis. mn line is parallel to new budget line which shows substitution effect.

In case of normal good, when price decrease quantity demanded in the market increases. Inferior goods also follow law of demand because quantity demanded have increased due to fall in the prices. But in case of Giffen goods ' law of demand is not followed. Here quantity demanded decreased due to decrease in price.

Answer A-D has been given below.